Worried about retiring amid inflation and lower returns from equities? This could be the answer

How has retirement investing changed over the last ten years, and where are we today?

What are the main challenges facing retirees today?

The poor old retiree who hasn't got all that experience running their own money has got to figure out, "How are they going to get income that keeps up with inflation?" 

And it's not something they've ever had to think about. While wages haven't worked too well in terms of keeping up with inflation in the last couple of years for people's working lives, they generally do. Now, they're in retirement, that's a bit of a struggle to sit there and go, "How do I get an income now that keeps up with inflation?"

What are the different paths retirees can take into retirement in terms of their different income needs?

What are some of the different ways retirees can generate their income?

When you're looking at generating income from your capital in retirement, there's a whole bunch of different ways you can actually do it. There's the stock standard, or stick money in a term deposit or another interest-bearing account, and you've got the interest on that side. It may be generating dividends or rent from your property, but if you start to think a little bit more creatively, you can find other ways that will generate income from that capital that's there. Some of these might include looking at equity-style investments, but using derivatives, generating income from that side, you can look at other capital-type products like the annuity, where it's automatically converting your capital to income on that side there. High-yield strategies can also generate a different style of income. I think for a retiree to look at a different range of how they're generating their income, it can be quite helpful.

What's the relationship between capital and income?

It depends on how you look at it. If you go and pull an economic textbook, they're going to tell you that income is the accretion to capital, which doesn't really mean a whole lot. Then you go off and think, "Let me go talk to my accountant." And he's going to have this definition of income that comes down to interest, dividends, and rent on the property, and then maybe some realised capital gains or something like that. It's very specific, but all that actually matters is how much money a retiree can spend. That depends on capital, because if you've got a pot of money, some capital sitting there and you happen to grow that because you've got some good investments, how much capital you've got left is going to depend on this income. It's like this identity that your income is just going to be your performance, less any change in your capital out there. That's something that creates this trade-off in terms of how you generate your income, what happens to your capital, and it changes how you can think about what you're doing in retirement.

Retirees move into retirement with different retirement balances. How does that relationship between income and capital change?

Generally, the more you've got saved up, the more you can afford your income through retirement. But it doesn't have to be that way. Now, someone who's got $10 million, for example, is a fair bit saved up. If they're churning through $1 million a year, it's actually not going to last very long. So they can end up spending it all. On the other side, if you've got, say, someone who goes from $5 million to $10 million, their income's not likely to double. The normal pattern there is that the more income or the more wealth you've got, your spending goes up, but not by as much. So this path between whether you're going to keep growing it, whether you're going to preserve it, or whether you're going to spend your capital does have a bit of a wealth flavour to it. But it varies across people and their own preferences.

How does the market cycle feed into all of this?

The market cycle runs alongside how this sits in here. When you're thinking about setting up something for retirement, what you're trying to do is you're trying to set up a portfolio that's going to work through the market cycle, and ideally, you've got something that works for the good and the bad markets in that sense there. That's really what I'm trying to do when I'm setting up a retirement income approach.

What are some of the main mistakes you see retirees or those just before retirement making?

I think one of the mistakes we see in retirement, and this was called out in the Retirement Income Review the government ran a couple of years ago, was that people tend to underspend. 

They get to the point where they've saved up, done a great job saving for retirement, they've got what they need, but when they look at what they're spending, they're not actually spending everything they probably could. We do work with groups like National Seniors and other surveys out there, and they ask retirees, "Why is this?" And they go, "I'm worried about, one, whether my money's going to last, and two, whether there's going to be something that comes along later on and it's going to be a big expense." So there's a lot of this worry about it, and they put it all off. Now, the trouble is, by the time they get to 85, 90 and realise they don't need the capital, it's a bit late to spend it then because that's not when they're doing all the travel and doing all the fun stuff they would've liked to have done when they were younger.

How do annuities work?

An annuity, at its heart, is a really simple asset. It's been around for centuries. It provides a very secure income stream, and there's two types of annuities. One that's like a term that is pretty familiar to most people. It looks like a term deposit; slightly different [there is no government guarantee on a term annuity] because it's run through a life insurer and not a bank, but you get a certain amount of money for a term. Three years and five years are more common than what you'd see with a term deposit. The other type is a lifetime annuity, and this is something that's been much more important with retirement. That basically says, for the upfront capital, you'll get paid an income stream for the rest of your life. It doesn't matter how long that is there. So it's a very simple construct that provides that certainty of getting an income stream for as long as you live.

What happens to the annuity if someone doesn't live for as long as they were initially planning to?

One of the things, and this is where the annuities were modernised probably a bit over a decade ago in Australia, there used to always be a guaranteed payment, but we incorporated a death benefit and the way it works, and there's government rules around what that can work with your super [the death benefit varies and is not available beyond life expectancy], but what it basically means is that if you say you're a 65-year old that starts an annuity now for lifetime, if you only last six years, but we'll give your estate your money back as this death benefit. There's not actually that many people that it impacts. It doesn't cost a lot, but it provides really good peace of mind that you've got that death managed, if the proverbial hit by the bus, you're not losing in that sense there. It really is about generating this secure income stream for retirement.

How can annuities complement super and equity portfolios?

Annuities are a great part of the solution. I think the last thing you'd want to do is load everything up on it because, when you look at what you need in retirement, you need a mix. You need some growth. Retirement's a long time. You can't stick it all in a defensive asset, and an annuity is a very secure defensive asset, and no one's going to sit out there 100% locked down. Maybe someone, but not really. It's part of this portfolio that sits in there and provides that security.

I say it's a little bit like the brakes on a race car. The whole idea of a race car is a car that goes fast. You'd think, "If I have something that slows me down, how does that help me go fast? It sounds a bit odd." That's exactly what it is because once you've got the brakes in there, then you can hit that accelerator knowing that you're going to slow down, knowing that if something goes wrong, you've got the security of the brakes, and the annuity is a bit like that in the portfolio. 

If you've got the level of secure income that you need, then you can go out and you can invest and take the growth assets and not worry what happens to the market cycles because yes, it'll go up and it'll come down, but because you'll have that secure income that you need, you haven't lost everything.

So it takes sequencing risk out of the equation a little bit?

It certainly reduces sequencing risk, unless you lock everything out of the market, you can't avoid some sequencing risk. 

With the annuity, by providing that secure income stream that doesn't go up and down with the market means, you miss that sequencing where, when the market dips, you're having to sell at the low. 

Now we all want to buy the dips. They all buy the dip mentality, but retirees, they've got to sell all the time. What you want to do is you want to avoid having to sell from the market or sell as much from the market when you have that dip. If you've got this layer of income, that provides a really good base.

What do annuities offer investors that traditional fixed-interest assets don't, namely bonds?

There's an American academic who's looked at this, and he calls annuities the bonds for retirement. He's talking here about the lifetime annuity because it's got that payment that lasts for life. When you're looking and thinking about what might happen when you run out, and this is in the jargon, it's the longevity risk or just making the money last as long as you do, that element of the annuity puts it ahead of bonds in the retirement phase, and you can get a much better mix of outcomes.